In this our second edition of Fenwick’s Securities Litigation and Enforcement Newsletter, we continue to provide you with short insights about timely securities litigation and enforcement developments. This edition’s topics run the gamut—from Delaware Courts challenging long-standing disclosure only settlements—to what happens when the SEC cannot crack the code—to a bit about Bitcoin—to the always important question of who pays the bills. We hope you find these topics useful. If you have questions or something you want to see in the next edition, we would love to hear from you.

This issue of the newsletter was edited by securities litigation partners Michael Dicke, formerly the Associate Regional Director for Enforcement in the SEC’s San Francisco office, and Catherine Kevane, with substantial assistance from associates Diana Chang, Jennifer Ebling, and Shannon Raj.

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And the Winner Is… The SEC Touts Record
Number of Cases for Its FY2015, and Highlights Innovative Firsts

The SEC’s enforcement numbers are in for its fiscal year
ended September 2015, and to no one’s surprise, the agency filed a record
number of enforcement cases. As
announced on October
22, 2015, the SEC filed 807 enforcement actions – an almost 7% increase
over the 755 enforcement actions filed in 2014. These actions resulted in approximately
$4.2 billion ordered in disgorgement and penalties, which is up slightly from
the $4.16 billion ordered in 2014. The
release also highlighted several “first-of-their-kind” cases, as well as the
SEC’s increasing use of cutting-edge data analytics to bring cases.

In the category of firsts, the SEC settled charges
against private equity firm Kohlberg Kravis Roberts & Co. L.P. (“KKR”) for
misallocating $17.4 million in “broken deal” expenses. According to the SEC, KKR incurred $338
million in such broken deal or due diligence expenses in pursuing unsuccessful
deals. According to the SEC’s
order, KKR did not equitably allocate those expenses, but instead allocated all
the expenses to its private equity funds without giving any allocation to the
private equity funds' co-investors, which consisted of KKR insiders and some
large clients. According to the
SEC, KKR failed to adequately disclose this practice, and “unfairly required the
funds to shoulder the costs.” To settle, KKR paid nearly $30 million
in disgorgement and penalties.

In another first,
the SEC charged
a bank, The Bank of New York Mellon Corporation (“BNY Mellon”), with FCPA
violations. BNY Mellon was charged with
providing internships to family members of foreign officials associated with an
unidentified Middle Eastern sovereign wealth fund in order to maintain its
contracts with the fund. The order also
found that BNY Mellon lacked specific controls to curb improper hiring, and the
bank paid $14.8 million in disgorgement and penalties to settle these
charges.

The SEC also delivered on its stated commitment to employ advanced
analytical tools to find misconduct. A recently unsealed
complaint shows that the SEC charged 32 defendants in a cyber-hacking
scheme that stole and traded on nonpublic corporate earnings reports to amass $100
million in illegal profits. The SEC
froze $70
million and secured a $30 million settlement against two of the defendants. Andrew Ceresney,
Director of the SEC’s Division of Enforcement, noted that the agency’s “use of
innovative analytical tools to find suspicious trading patterns and expose
misconduct demonstrates that no trading scheme is beyond our ability to
unwind.”

Other significant cases include a continued focus on
financial fraud cases and misconduct by investment advisors, including (1) a suspension
order in 128 inactive penny stocks issued as part of the ongoing initiative,
Operation Shell-Expel, to suspend trading in ever-increasing pump-and-dump
schemes; (2) an order against BlackRock Advisors, LLC for failing to disclose conflicts of interest,
which resulted in $12 million settlement; and (3) a settlement with First Eagle
Investment Management, LLC for improper use of assets to pay for fund share
distributions that resulted in a $40 million settlement.

The Bottom Line:
The SEC is delivering on its promises to assert its presence in emerging areas
of first impression and to use new, advanced technologies to root out perceived
misconduct.

A new line of Delaware decisions promises to reshape
settlement norms surrounding stockholder litigation challenging mergers. It
will come as news to no one that, under today’s legal landscape, a shareholder
lawsuit comes closely on the heels of virtually all large public company
mergers. According to a 2015 Cornerstone Research study, in each year since
2010, over 90 percent of M&A deals draw a shareholder lawsuit. Until recently, the vast majority of
these suits have resulted in quick court approvals of settlements that require
only that the company make additional public disclosures and pay plaintiffs’
attorneys' fees, and in exchange provide broad releases for company and
individual defendants. But of late
Delaware courts have been pushing back and signaling that they will no longer
sanction this practice, calling such settlement agreements nothing more than a
way for plaintiffs' lawyers to earn fees.

Disclosure-only settlements were recently slammed on
October 9, 2015, when the Delaware Court of Chancery rejected a settlement of
the lawsuit stemming from Hewlett-Packard’s $2.7 billion acquisition of Aruba
Networks. See In re Aruba Networks, Inc. Stockholder Litig., Cons. C.A. No.
10765-VCL (Del. Ch. Oct. 9, 2015). There, the parties negotiated an agreement under which defendants would
provide supplemental disclosures in a Form 8-K, plaintiffs’ counsel would
receive a fee award, and defendants would receive a global release of
claims. Finding that the additional
disclosures provided minimal value to shareholders, Vice Chancellor Laster
stated, “[w]e have to acknowledge that settling for disclosure and giving the
type of expansive release that has been given has created a real systemic
problem.” He declared the
settlement “outside the range of reasonableness” and said the case appeared to
be set up as a case for plaintiffs' counsel to “harvest” fees “because there
wasn’t a basis to file in the first place.”

This result was not entirely surprising: Less than a month
earlier, the Court of Chancery expressed serious reservations about approving
disclosure-only settlements in no uncertain terms. In that case, In re Riverbed Technology, Inc., Cons. C.A. No. 10484-VCG (Del. Ch.
Sept. 17, 2015), Vice Chancellor Glasscock noted that, in the particular case
before him, “the parties in good faith negotiated a remedy—additional
disclosures…with the reasonable expectation that the very broad, but hardly
unprecedented released negotiated in return would be approved by this Court,”
but stated that such expectations would be “diminished or eliminated going
forward.” Vice Chancellor Glasscock
found particularly troubling the breadth of the release, especially when
weighed against the value of the disclosures, which he compared to a mere
“peppercorn.” This echoes comments
made by Vice Chancellor Laster this summer in rejecting the settlement
following Cobham plcC’s $1.5 billion Aeroflex deal. There, he declared a settlement
providing only disclosures, plus two “tweaks” to the merger agreement, to mean
that “[t]he class…gets nothing. Zero. Zip.” See
Acevedo v. Aeroflex Holding Corp., No. 7930-VCL (Del. Ch. July 8,
2015).

The Bottom
Line: It remains to be seen
whether these recent decisions herald the end of disclosure-only settlements in
Delaware. But given this trend, a
Delaware corporation seeking to settle a merger suit should carefully consider
additional settlement conditions, the language of its settlement release, and
stand ready to demonstrate the proportionality between the settlement terms and
the release itself.

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Game of Phones:
Employer-Issued Smartphones and Employee Fifth Amendment Protections

A
recent court decision holding that employees can claim the Fifth Amendment and
refuse to unlock password-protected smartphones, even though the phones were
issued by their employer for company business, demonstrates the increasing
difficulty companies face in managing and protecting corporate
information. The holding in SEC v. Huang, No. 15-269 (E.D. Pa. Sept.
23, 2015), arose following an SEC insider trading action against two former
Capital One data analysts. Capital
One had provided the SEC with the smartphones used by its employees, which had
been issued by Capital One and which were used by the employees to conduct
company business. However, the SEC
was not able to access documents on the phones without first inputting the
passcodes used to protect the phones. The company did not know the passcode, and as a matter of policy, did
not ever require employees to provide the bank with their smartphone
passcodes. Citing the Fifth
Amendment privilege against self-incrimination, the employee defendants refused
the SEC’s demand to reveal the passwords, and the SEC moved the court for an
order compelling production.

In
considering the SEC’s motion to compel, the court noted the importance of the
issue:

We
now consider another perspective on the interplay of mobile technology,
employer rights
and former employees' Fifth Amendment protections from disclosing personal
secret passcodes
created by Defendants, with their former employer's consent, to access the smartphones owned by their former
employer.

Huang, at page 1. The court reviewed the long history of
Fifth Amendment jurisprudence, noting that more than a decade ago, the Supreme
Court differentiated the act of revealing “the combination to a wall safe” from
“being forced to surrender the key to a strongbox,” as the first was
testimonial rather than physical in nature. U.S.
v. Hubbell, 530 U.S. 27 (2000). That opinion has been cited to allow a defendant to refuse to produce
his computer passcodes, and the Eleventh Circuit has held that the Fifth Amendment
protects an individual accused of possessing child pornography from having to
decrypt a hard drive. See In re Grand Jury Duces Tecum Dated March
25, 2011, 670 F.3d 1335 (11th Cir. 2012); United States v. Kirschner, 823
F. Supp. 2d 665 (E.D. Mich.2010). In
contrast, providing fingerprints to unlock a smartphone has been deemed not testimonial in nature. See
Virginia v. Baust, No. CR14-1439 (Va. Cir. Ct. Oct. 28, 2014).

The SEC claimed that the two former employee defendants were
corporate custodians of business records, which are not subject to Fifth
Amendment protection, and thus should be compelled to disclose the passcodes to
enable the SEC to obtain the business records. The court disagreed, finding
that the SEC “is not seeking business records[,] but Defendants’ personal
thought processes.” It highlighted
the fact that Capital One had instructed its employees not to share or keep any
records of the passcodes to find that “the act of producing their personal
passcodes is testimonial in nature.” Thus, the court refused to order the
employees to reveal the smartphone passcodes.

The Bottom Line: In a world where employer-issued
smartphones are increasingly commonplace and used to conduct critical business
in real-time, the Huang decision poses new challenges not only for government investigators, but also for
companies seeking to protect and manage corporate information. In light of Huang, companies would be wise to evaluate their device and
password policies to ensure that they address the new and emerging
technological and business realities.

As our last
newsletter highlighted, the government is ramping up enforcement
investigations against both regulated entities and public companies for
perceived cybersecurity failures. Proving
the point, on September 22, 2015, the SEC announced its
first-ever cybersecurity enforcement action. The SEC alleged that registered
investment adviser R.T. Jones Capital Equities Management failed to establish
cybersecurity policies and procedures reasonably designed to safeguard customer
information, as required by Rule 30(a) of Regulation S-P under the Securities
Act of 1933. The SEC found that the
firm failed to conduct periodic risk assessment, implement a firewall, or
encrypt sensitive customer information prior to a data breach that compromised
the personal information of approximately 100,000 individuals, including many
of the firm’s clients. Without
admitting or denying the SEC’s findings, the firm agreed to be censured and pay $75,000 penalty to settle the matter.

The SEC has been messaging for some
time that it would bring an enforcement case against a regulated entity for
violation of the specific cybersecurity rules in Regulation S-P, and similar
actions are likely to follow shortly. In the wake of the R.T. Jones announcement, SEC
Chair Mary Jo White warned “it is incumbent upon private fund advisors and
other regulated entities to employ robust, state-of-the-art plans to prevent,
detect, and respond” to cybersecurity risks. And while public companies are not
subject to Regulation S-P or any specific SEC rules about their cybersecurity
practices, the SEC has signaled that it is closely examining the accuracy and
completeness of public company disclosures about their cyber policies and risks
to the business from a cyber incident, as well as disclosures following a cyber
breach.

The Bottom Line: Expect
additional SEC scrutiny of cyber policies and practices of both regulated
entities and of public company issuers.

Do Not Pass Go. Do Not
Collect $200?: D&O Insurance—Advance Warning on Fee Advancement

In a recent string of decisions,
the Delaware Chancery Court has addressed the scope of the right of Directors
and Officers to have their legal expenses paid while governmental investigations
or legal proceedings against them are pending.

In Blankenship
v. Alpha Appa​lachia Holdings, Inc., decided last spring, the former CEO and Chairman of Massey
Energy Company, Don Blankenship, retired “not entirely voluntar[ily]” following
a deadly explosion at one of the company’s coal mines. C.A. No. 10610-CB (Del. Ch. May 28, 2015). Shortly thereafter, the company was
acquired by Alpha Natural Resources and the former CEO signed a new undertaking
stating the company’s advancement of his legal expenses was contingent upon his
representation that he “had no reasonable cause to believe that [his] conduct
was ever unlawful.” Initially, the
company paid Blankenship’s legal expenses arising out of the government’s investigation
of the explosion. But the company ceased
paying such expenses when Blankenship was criminally indicted, concluding that Blankenship
had breached his undertaking and was no longer entitled to advancement.

When Blankenship initiated an action
seeking advancement of his defense costs, the Court of Chancery observed the
facts fit the “all too common scenario” where “mandatory advancement” to a
former director and officer is terminated “when trial is approaching and it is
needed most.” The court found that
Blankenship’s advancement rights under Massey’s charter survived pursuant to
the merger agreement. Relying on
contract interpretation principles, the court further found the undertaking in
the agreement between Massey and the company could not be construed to alter
the company’s advancement obligation. Thus, the court concluded Blankenship was entitled to advancement of
his defense costs.

The Blankenship decision is consistent with Holley v. Nipro Diagnostics, Inc., a
Court of Chancery ruling from last year. C.A. No. 96779-VCP (Del. Ch. Dec. 23,
2014). In Holley, the court held the
founder and chairman of a medical device company was entitled to advancement to
pay for the cost of defending an SEC civil enforcement action for insider
trading after pleading guilty to criminal counts arising out of the same
conduct.

As a September 2015 Delaware Court
of Chancery opinion demonstrates, however, there can be limitations to
advancement rights. In Charney v. American Apparel Inc.,
the court held the founder and former Chairman and CEO of American Apparel clothing
company, Dov Charney, was not entitled to advancement to cover the legal expenses
he incurred while defending an action brought against him by the company. C.A. No. 11098-CB (Del. Ch. Sept. 11,
2015). Previously, following the Board’s
suspension of Charney, the Board and Charney, in his personal capacity, entered
into a standstill agreement and Charney resigned as a director of the
company.

Some months later, the company sued
Charney for allegedly breaching the standstill agreement for, among other
things, discussing with a private equity firm a potential takeover of the
company. Charney then brought an
action seeking advancement to cover the costs of defending the company’s action. The Court of Chancery found that the
indemnification agreement mandating advancement for events “related to the
fact” that the founder is a director or officer of the company should be
construed to require “a nexus or causal connection between the claims in the
underlying proceeding and one’s official capacity” in order to obtain
advancement. The court concluded
that because none of the claims in the proceeding for breach of the standstill
agreement “implicate his use or abuse of corporate power as a fiduciary” of the
company, Charney was not entitled to advancement to defend against the
claims. The court separately also concluded
that Charney was not entitled to advancement because the company’s charter
mandated advancement only for current directors and officers.

The Bottom Line: Delaware law provides strong protections for the right of directors and
officers to obtain advancement of legal expenses incurred for investigations or
claims causally connected to their positions, but these protections are not
ironclad. Directors and officers
should be aware that they may not be entitled to advancement to cover legal
fees to defend actions that do not arise from their official fiduciary duties. Companies may want to review their
governing documents and advancement provisions in light of these recent
decisions to ensure that they clearly reflect the company’s intent regarding
the reach of advancement.

The SEC continues to focus on accounting and disclosure
violations, including in the area of executive perks disclosure in corporate
proxy statements. In the past year,
the SEC brought two enforcement cases against executives and companies for
failure to fully disclose executive perks. In one of the matters, the SEC took the unusual and provocative step of
suing the company’s audit committee chair because he “had reason to know” that
the perks had not been fully disclosed in the company’s SEC filings. Taken
together, these two actions are a harbinger of the SEC’s intensifying scrutiny
of executive compensation disclosures.

Under Rule
14a-3 of the Securities Exchange Act of 1934, companies with Section 12
registered securities must provide proxy statements that include executive
compensation disclosures in accordance with Item
402 of Regulation S-K prior to shareholder meetings. In turn, Item 402 requires disclosure of
the total value of any executive perks which exceed $10,000 in a given
year. The failure to disclose such
executive perks may violate Rule
14a-9 which prohibits corporations from issuing proxy statements containing
materially false or misleading statements or omissions.

On March 31, 2015, the SEC filed a fraud complaint
against Andrew Miller, the former CEO of San Jose-based company, Polycom, Inc.
(“Polycom”), for failure to disclose almost $190,000 in executive perks in its
proxy statements. In what the SEC
called an “expense
abuse scheme,” Miller allegedly described
extravagant personal expenses, like trips to Bali with guests, as legitimate
company expenses. The SEC further
alleges that Miller directed that personal or other expenses be buried in other
budget items. The SEC is litigating its case against Miller​ in federal court, and Miller resigned from Polycom in July 2013.

The SEC also charged Polycom in a separate order that
included allegations that the company violated the internal controls provisions
of the securities laws by allowing Miller to self-approve certain of his own
falsified expenses, book and charge travel without valid business descriptions,
and issue company purchasing cards to himself and his assistants to charge his
certain personal expenses. The SEC
order found that Polycom violated the
proxy disclosure rules by failing to report the perks detailed in the complaint
against Miller, notwithstanding the fact that there was no allegation that
anyone at the company knew about the fraudulently obtained perks. Polycom paid $750,000 to settle all
charges.

Just a few months later, the SEC brought and settled charges
against MusclePharm Corporation (“MusclePharm”), several of its executives, and
its former audit
committee chair for failure to disclose nearly $500,000 in executive perks,
including meals, private cars, golf memberships, and other lavish personal
expenses. MusclePharm, a sports
nutrition and supplement company, settled these charges and the company and
individuals each paid a civil penalty. Notably, MusclePharm was also required to hire an independent
consultant for one year to review expense reporting and recommend proper
financial disclosure policies.

The Bottom Line: As highlighted by Andrew J. Ceresney,
Director of the SEC’s Division of Enforcement, “[e]xecutive compensation is
material information for investors, and companies must ensure that perks it
pays for executives are properly recorded and disclosed in public
filings.” Companies should consider
that highly visible perks provided to executives -- such as use of the
company jet, club memberships, and the like -- will receive extra scrutiny by
the SEC and thus warrant additional consideration both in approving and
disclosing the perks. Boards and
compliance personnel of public corporations need to ensure that their companies
have proper controls to approve and account for the value of perks, and that
the proxy disclosure rules are then scrupulously followed.

The Commodity Futures Trading Commission (“CFTC”) and the
SEC are flexing their regulatory muscles
to rein in securities and commodities rules violations by start-up companies in
the virtual currency space. On September
17, 2015, the CFTC settled
charges against SF-based company, Coinflip, Inc. (“Coinflip”) for
violations of the Commodity Exchange Act. Just a week later, the CFTC also settled
charges against a temporarily registered swap facility, TeraExchange LLC
(“TeraExchange”), for failing to enforce its rules against wash trading. Similarly, the SEC has brought several enforcement​ cases
against bitcoin operators within the past 18 months, after declaring
that interests tied to the value of virtual currencies are securities subject
to SEC regulation. The agencies’
increasing interest in regulating and enforcing rules around digital currencies
comes amid growing acceptance of virtual currency like bitcoin, as well as a massive
ru​n-up in price for bitcoin this month.

The CFTC’s action against Coinflip is noteworthy as the
first time that the agency has held in an enforcement case that bitcoin and
other virtual currencies are commodities subject to the Commodity Exchange
Act. Coinflip operated an online
platform for about 400 buyers and sellers of bitcoin-based derivatives, called
Derivabit. In its order,
the CFTC found that Coinflip and its chief executive officer, Francisco
Riordan, failed to comply with CFTC regulations and the Commodity Exchange Act,
including regulations requiring registration of facilities dealing in commodity
transactions. The charges were
settled without monetary sanctions. The Coinflip and TeraExchange cases follow a statement
from CFTC Chairman Timothy Massad in December 2014 that “[d]erivative contracts
based on a virtual currency represent one area within our responsibility.”

The SEC also has been steadily staking out its territory
as an enforcer of securities laws for interests tied to the value of virtual
currencies. Following its May
2014 Investor Alert detailing the risks of virtual currency, the SEC brought
several enforcement actions against bitcoin industry
operators. In addition, news
reports and court filings reveal that the SEC is investigating GAW Miners
(“GAW”) and its Chief Executive Officer, Josh Garza. The investigation
is examining whether GAW’s sales of its mining technology product and virtual
currency, paycoin, violated the anti-fraud provision and other provisions of
securities laws. Significantly, a
number of the SEC enforcement investigations are being conducted by members of
the SEC’s Digital Currency Working Group, indicating that enforcement resources
are flowing into investigations focused on the virtual currency arena.

The Bottom line: Digital currency like bitcoin will continue to
attract innovators and will continue to gain acceptance. But as the CFTC’s Director of
Enforcement recently said, “innovation does not excuse those operating in
this space from following the same rules.” Regulatory agencies like the SEC and CFTC will continue elbowing each
other to assert enforcement jurisdiction over the virtual currency market. Companies and individuals operating in
this space should be prepared to deal with changing regulations and the
potential for multiple agencies attempting to regulate the same transactions or
conduct.